Bernanke: Fix banks to get a recovery

NEW YORK (CNNMoney.com) -- Federal Reserve chairman Ben Bernanke said Tuesday that economic recovery hinges on stabilizing the financial system, and proposed new policies aimed at absorbing financial shocks in the future.

"Until we stabilize the financial system, a sustainable economic recovery will remain out of reach," Bernanke said in prepared remarks.

If the financial system is put back in order, the U.S. economy could work its way out of recession "later this year" and experience "a period of growth" next year, Bernanke said.

"In the near term, governments around the world must continue to take forceful and, when appropriate, coordinated actions to restore financial market functioning and the flow of credit," he said.

The Fed chairman said steps should be taken to address problems tied to financial institutions deemed too big to fail. These large, interconnected financial firms pose a "systemic risk" to economic stability, he said.

"In the present crisis, the too-big-to-fail issue has emerged as an enormous problem," he said.

Bernanke said allowing firms to become too big to fail reduces market discipline and encourages excessive risk-taking. Moreover, government rescues of firms that are too big to fail can be costly to the taxpayer, he said.

Speaking in Washington to the Council on Foreign Relations, Bernanke said regulators need new tools to respond to the failure of a "systemically important nonbank financial firm." Federal bankruptcy laws are not sufficient to protect the public's interest when a major nonbank financial firm fails, he said.

The comments came one week after the Treasury Department restructured its bailout of insurance giant American International Group (AIG, Fortune 500) and gave the company another $30 billion infusion.

Bernanke also said regulators should strengthen the nation's "financial infrastructure" to make it more secure in the event of another crisis.

Among other things, the Fed and other regulators will continue to work toward establishing "stringent targets" and "performance standards" for market participants, he said.

To that end, the government should work with the private sector to improve the way certain exotic derivatives, such as credit default swaps, are cleared from the market.

Bernanke also said that more steps should be taken to support the credit and mutual fund markets. The Fed has emergency programs in place to increase liquidity in these markets.

Additionally, certain accounting rules and other regulations have made the financial sector excessively "procyclical" or sensitive to economic booms and busts.

To assess threats to the broader economy, Bernanke proposed that Congress create a "systemic risk authority." The authority could oversee, among other things, standards for capital, liquidity, and risk-management practices for the financial sector, he said.

Talkback: Do you know any heroes of the economy? Someone like Leonard Abess, the Miami banker who shared his $60 million bonus with his employees? Or maybe someone acting on a smaller scale to help those suffering during this recession. Maybe you? Send an email to realstories@cnnmoney.com, and your nominee could be profiled in an upcoming CNNMoney.com article.